By-Lined Article
Integration vs. a Second Bite at the Apple
By Duane Morris Private Equity Connections
Summer 2012
Duane Morris Private Equity Connections
Beyond the dollars and cents, the biggest question any buyer must answer is, "What will my business look like if I sell it to you?" Some entrepreneurs may not like the answers they receive from strategic bidders. Private equity buyers can offer more creative options for continued ownership, particularly for entrepreneurs who are looking more for a partner, rather than a buyer.
At Roark Capital, "we like to talk with a seller to figure out their objectives and tailor a deal that works for them," says Bryant. "What role do they want to play in operating the business? Do they want to continue to run it? What type of financial participation do they want going forward, versus what they're looking to monetize at the time of the deal?"
Bryant notes that oftentimes, "we've had situations where we acquired 100 percent of the selling assets and compensated the entrepreneur through continued ownership, traditional stock option plans and incentives of that nature, or we've had entrepreneurs who maintained control and we came in and had a significant minority investment."
Private equity buyers can work these options hard to win a deal. "We offer some of the best of both worlds—as a financial buyer and also as a strategic buyer," says Roark Capital's Bryant. With private equity backing, a company could accelerate international expansion or brand positioning or buy up a few competitors. "This would be similar to what a strategic could do," says Bryant. "From the standpoint of financial buyers, we can also offer them some continued independence. We're involved at the board level. We're not running the companies that we own on a day-to-day basis. A lot of their reporting structures can stay in place."
"We're involved at the board level. We're not running the companies that we own on a day-to-day basis. A lot of [the seller's] reporting structures can stay in place." Robert Bryant, Roark Capital
In addition to keeping a hand in management, a private equity deal means entrepreneurs can leave some of their money on the table to share in the future value creation of the enterprise. At Riverside, Ibrahim says the fund might take an 80-percent stake and ask the management team or family owners to roll 20 percent of their equity into the new enterprise. "What we're offering is a way to help management grow their companies through add-on acquisitions, through our relationships, through our operational program," said Ibrahim. In return for their rollover equity stake, they can then enjoy the same returns as Riverside's LPs.
This is a compelling argument for sponsors such as Riverside because "over our 24-year history, on average, we hold companies for less than five years and return 3.4-times gross cash upon exit," says Ibrahim. "So what we're saying is instead of paying you $20 million for equity now, based on our historical cash-on-cash returns, you would anticipate that $20 million would grow to $68 million (a 3.4-times cash-on-cash return). If you're an average investment with Riverside, that's what you can expect."
"Most of our management team has in fact joined our company through acquisitions. . . . The good thing about being part of a larger enterprise is that you can expand your scope of responsibility because there is room in this company." Steve Voorhees, RockTenn
Selling to a Strategic Buyer is a Different Story
While multiples may be on the higher side of the range with strategics, the question of integration is always present. Where operations are duplicated, there will be the inevitable pink slips. This is particularly true for human resources and finance departments, where duplication is virtually a given. Entrepreneurs who put their companies on the block are going to ask: "What will happen to my management team? What's going to happen to me? What's going to happen to my employees?"
How these questions are answered can make or break a deal. "Where you have people who have their lives and sometimes their families wrapped up in the business, this can be a complicated series of questions you have to get through," says RockTenn's Voorhees. Yet redundancies are not across the board. "Most of our management team has in fact joined our company through acquisitions," he said.
Indeed, Voorhees knows a great deal about integrating teams and systems. Last year, RockTenn acquired a much larger competitor, Smurfit-Stone Container, to create the second-largest manufacturer of corrugated packaging in North America.7 "Overnight, RockTenn's revenues tripled," says Voorhees. "It's an experience you really can't describe, getting involved in the integration of a company that is two-and-a-half times as big as you are," he says. He speaks from experience when he tells prospective acquisitions: "The good thing about being part of a larger enterprise is that you can expand your scope of responsibility because there is room in this company."
Voorhees recalled one acquisition that required a full "charm offensive." The firm was owned by two brothers, one of whom had a list of companies to whom he did not want to sell. "We had to work pretty hard to get him even to talk to us, but we were successful," says Voorhees. What sold the idea was the opportunity Rock-Tenn created for the management team. "The managers who have chosen to stay with us have had very successful careers," he says.
"I love to buy from sponsors because they know what we need to complete the diligence and execute a deal. . . . Sponsors make my life easier. And, if they're in a process with us, it keeps us all honest." Ronald Chang, UPS
Option for Strategics: A Second Bite at the Apple
Some strategic buyers are even trying to incorporate their own version of a second bite at the apple with earnouts. "If we're having trouble bridging the gap in terms of valuation, we'll help you get there," says UPS's Chang. "So, you stick around, hold your team accountable and work with us, in terms of identifying synergies." He says UPS does not mind giving up some of the upside in these situations. "I'll take a percentage of something, versus 100 percent of nothing," he quips. Chang finds though that when it's time to put pen to paper, most business owners opt for a fixed price.
Most strategics are not keen on earn-outs, even if they offer them grudgingly and with excruciatingly detailed paperwork. "This is not one of my favorite transaction structures," says RockTenn's Voorhees, "because an argument can occur if the terms are not understood by all. We've been more successful just agreeing on a valuation that creates what we think is the market-clearing price," he said.
Therefore, it would seem that strategics have adopted some of the buying strategies of financial sponsors, and sponsors in turn are finding new and more creative ways to keep their edge in the dealmaking battles. Says Roark Capital's Bryant, "I think you're seeing a blend, especially for industry and sector-focused private equity firms. They don't act like pure financial buyers anymore. They're looking more like strategics. I think you're also seeing strategic buyers like UPS, where they have in-house M&A and corporate development groups where they can—through speed to market and certainty of close—act more like a financial buyer."
UPS's Chang concurs on the convergence of styles, but also maintains a keen appreciation of how strategic and sponsor roles interact: the "co-petitive" view. "I love to buy from sponsors because they know what we need to complete the diligence and execute a deal." Chang says he's well aware of the "us versus them" expectations of the M&A marketplace, especially in the middle market, but he's content with the terms of the contest. "Sponsors make my life easier," he says. "And, if they're in a process with us, it keeps us all honest."
The Duane Morris View
Richard Silfen: Despite significant differences between financial and strategic acquirers on virtually every dimension—economics, business objectives, diligence styles and operating processes—the dual priorities for sellers remain: understand your own business (and personal) objectives and spend the effort on early preparation. Quality sponsors are prepared to craft strategies that make life easier and potentially more profitable, even though in-going pricing may not look as immediately attractive as what is available from a strategic. Up-front consultation with the transactional support team of lawyers, bankers and accountants will virtually always yield a smoother, superior outcome.
